Markets Don’t Need a Fed Statement to Know Where QE Is Headed
We’re not here to give out romantic advice, but the key to any relationship is communication. This is a lesson that central banks around the world — and the U.S. Federal Reserve in particular — are in the process of learning. Recent market volatility has been blamed on speculation about the future of quantitative easing, and it’s unclear if confusion and uncertainty is the result of poor communication from the Fed, or the failure of of the market.
For the record, Chairman of the Fed Ben Bernanke has made it clear that he recognizes the necessity of effective communication with the market. Each round of quantitative easing has left another lesson in its wake, and the latest iteration of the program is an evolution from previous programs. Historically, QE programs involve purchases of a fixed amount of assets over a predetermined period of time, whereas the current program is defined by a flow rate of purchases.
QE1, which lasted from November 2008 to March 2010, began as a program to purchase $500 billion in mortgage-backed securities, although total purchases expanded to $1.25 trillion. QE2 was an extension of QE that included the purchase of $600 billion of longer-term Treasury securities. Effectively, the Fed said that it was going to put a fixed amount of fuel into the economy, and see how far that got us.
This strategy clearly produced underwhelming results. After each round of stimulus, markets usually backtracked as the fuel ran out. With QE4, the most-recent iteration of the program, the Fed did not announce that it would be buying a predetermined quantity of assets. “The difference with this program,” as Bernanke put it in a testimony before Congress, “is that we are buying a flow rate. We’re buying a certain amount of assets each month, and the amount that we purchase will depend on the data coming in.”
The incoming data is being interpreted against benchmarks the Fed set at the beginning of 2013. The criteria for a policy shift were set at a 2.5 percent inflation threshold (with a 2.0 percent target) and a 6.5 percent unemployment rate target. With these conditions in place, the Fed has effectively said that it will keep its foot on the gas until there is enough evidence that economic conditions have improved enough to warrant tapering purchases.
By setting forward guidance as a function of labor market conditions, the Fed is trying to avoid a pessimistic signal problem. Speaking before Congress, Bernanke said: “We’re trying to make an assessment of whether or not we have seen real and sustainable improvement in the labor market outlook. This is a judgement that the committee will have to make.”
This judgement component of the strategy is what seems to have markets on edge. During the hearing, Bernanke said that if conditions change fast enough, policy could change in the next few months. Speaking in Sweden last Monday, San Francisco Fed President John Williams suggested that conditions are at or nearing the condition of sufficient improvement.
“It really is a question for me of watching for continuing signs in the U.S. labor market, continuing signs of more greater confidence in the momentum in the U.S. economy, but also watching carefully where the underlying inflation rate is and what the outlook for inflation is,” Williams told reporters.
With all this said, it looks like the Fed is expecting the markets to take a chill pill and take a step back from hanging on its every word. Echoing a sentiment expressed by Bernanke about what the markets should expect from the Fed, Williams said that with the current forward guidance in place, “members of the public can adjust their expectations for future Fed policy as new information on the economy becomes available.”
He continued: “They don’t need to wait for the Fed to issue a new statement. For example, a slowdown in economic growth might cause the public to think that the prospect of reaching a 6½ percent unemployment rate was falling further back in time. They would then expect the Fed to wait longer to raise the federal funds rate, which would prompt them to push long-term interest rates down. And those lower long-term rates would help us achieve our monetary policy goals.”
Bernanke expressed his feelings on the matter this way: “Well, we’ve explained the strategy, and the market can see the data as well as we can.”
Here’s how markets closed Monday:
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